Tax Consumption, Not Savings

Bruce Bartlett writes for The Fiscal Times and Tax Notes and was a Treasury Department economist during the George H.W. Bush administration. His latest book is "The New American Economy: The Failure of Reaganomics and a New Way Forward."

Updated October 2, 2013, 12:41 PM

We have a growing debt problem that is too large to stabilize just with spending cuts. Therefore, tax increases will have to be part of the solution. The magnitude of the necessary tax increase, however, is so large that it would cripple the economy if achieved through higher income tax rates.

A value-added tax can raise revenues by taxing consumption while minimizing damage to growth.

The Congressional Budget Office estimates the long-term revenue trend to be 19 percent of gross domestic product once the recession is well past. It also projects spending will rise to 35 percent of G.D.P. by 2035 absent legislation to slash Social Security, Medicare and Medicaid. Completely abolishing every other program, including national defense, will not be enough to prevent a substantial spending increase.

It’s unrealistic to think that spending is going to be cut by 16 percent of G.D.P., which would be necessary to balance the budget without a tax increase. But financing just a third of the deficit reduction on the tax side will require net new revenue of more than 5 percent of G.D.P. Such a large tax increase must be achieved in a way that minimizes damage to incentives and growth. A value-added tax can do that by taxing only consumption and exempting saving.

But a VAT needs two to three years to implement. If enacted now, it could provide the revenue for reforming the tax code, permanently fixing the alternative minimum tax, and possibly abolishing the corporate income tax. When Congress is ready to adopt serious deficit reduction, a VAT will then be available to raise additional revenue without raising income tax rates.